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On May 19, 2008, the IRS adopted final regulations on the tax attributes that must be taken into account in determining whether allocations of partnership income, expense, and other items have “substantial economic effect” where one or more of the partners is a controlled foreign corporation or other “look-through” entity¹ or is a member of a consolidated tax group. Like the regulations proposed in November of 2005, the final regulations provide that the determination of substantial economic effect in such a case must take into account the interaction of the allocation with the tax attributes of any person that owns an interest in the look-through entity or of any member of the same consolidated tax group as the partner. This applies through tiers--the determination would, for example, take into account the tax attributes of a partner in a partnership that was in turn a partner in the tested partnership.²

Suppose, for example, there is a special allocation of non-Subpart F income of a partnership to a partner that is a controlled foreign corporation and that the other partner is a U.S. corporation. This is, substantively, an allocation of tax-exempt (or at least tax deferred) income to the shareholders of one partner, assuming that the controlled foreign corporation pays no dividends; and whether the economic effect, if any, of the allocation is “substantial” would under the final regulations have to take this into account, i.e., would have to consider the after-tax consequences of the allocation to the U.S. shareholders of the controlled foreign corporation.³

The important changes made to the proposed regulations by the final regulations are the addition of a rule (the “de minimis partner” rule) which provides that the tax attributes of a partner who owns less than 10% of the capital and profits of the partnership, and who is allocated less than 10% of each partnership item, need not be taken into account; and a rule which treats a controlled foreign corporation as a look-through entity only if its shareholders own at least 10% of the capital and profits of the partnership. The Preamble, suggesting possible further relaxation of the rules, says that further consideration is being given to whether a controlled foreign corporation partner should be treated as a look-through entity in all cases and how taxable dividends paid by a controlled foreign corporation partner should be taken into account in determining the substantiality of an allocation.

While by no means limited to the foreign operations of U.S. corporations, that is obviously one area in which the final §704(b) regulations may be important (and indeed the only substantive example added by the final regulations applies the rule to an allocation of Subpart F and non-Subpart F income by a partnership in which one partner is a controlled foreign corporation and the other is a taxable U.S. corporation).⁴ In this context, the final regulations are part of a set of regulations dealing with partnerships or disregarded entities that conduct operations outside of the United States--first, the regulations adopted in November 2006 with respect to the allocation among partners for foreign tax credit purposes of foreign taxes; second, the regulations proposed in August 2006 (and expected to be adopted in next fiscal year) with respect to the identity of the taxpayer (i.e., the so-called “technical” taxpayer rule) for purposes of the foreign tax credit, which deal both with the allocation of foreign income taxes imposed on the income of more than one legal entity and with the allocation of foreign income taxes imposed on reverse hybrid entities.⁵

The connection of the final regulations under §704(b) with the rules for allocating foreign income taxes paid by a partnership is clear--in the example given at the outset, if the Subpart F income of the partnership was subject to one rate of foreign tax and the non-Subpart F income to a different rate, the conclusion that the special allocation did not have substantial economic effect would impact not only what the partners took into income on a current basis but would also change the foreign tax credit allowed for the foreign income taxes paid on the income.

Prior to the adoption of the final §704(b) regulations, whether allocations had substantial economic effect was determined by evaluating the consequences to the “partner,” with no suggestion in the text of the regulations that this required an evaluation of the consequences to any related legal entity. Although the change made in the final regulations is by its terms effective only for taxable years of a partnership that begin on or after May 19, 2008, the Preamble nonetheless describes the change as a “clarification,” stating further that “the final regulations merely confirm the proper application of the substantiality test in those instances in which the partnership is owned by one or more look-through entities,” and that “the look-through rule in the final regulations is not a change to the substantiality test.” One of the three examples in the final regulations also makes the point that allocations may be challenged under other principles, including §482.

Does the Preamble to the final §704(b) regulations signal the possibility of a challenge for periods prior to the effective date? The regulations relating to the allocation among partners of foreign taxes are applicable, generally, to taxable years of a partnership ending on or after October 19, 2006, but it is worth noting that litigation has begun with respect to whether, in a year prior to the effective date, an allocation of foreign taxes based on the allocation of the foreign tax expense had substantial economic effect and should be respected.⁶

The Preamble to the final regulations also states that consideration is being given to issuing additional guidance on special allocations of a partnership that is “owned primarily by related parties.”

This commentary also will appear in the August 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Stoffregan, Harris, and Wirtz, 910 T.M., Partners and Partnerships -- International Tax Aspects, and in Tax Practice Series, see ¶7110, Foreign Income Taxation: General Principles.